The financial crisis highlighted that public authorities are ill-equipped to deal with ailing banks operating in today's global markets. In order to maintain essential financial services for citizens and businesses, governments have had to inject public money into banks and issue guarantees on an unprecedented scale: between October 2008 and October 2011, the European Commission approved €4.5 trillion (equivalent to 37% of EU GDP) of state aid measures to financial institutions1. This averted massive banking failure and economic disruption, but has burdened taxpayers with deteriorating public finances and failed to settle the question of how to deal with large cross-border banks in trouble.

The proposals adopted today by the European Commission for EU-wide rules for bank recovery and resolution will change this. They ensure that in the future authorities will have the means to intervene decisively both before problems occur and early on in the process if they do. Furthermore, if the financial situation of a bank deteriorates beyond repair, the proposal ensures that a bank's critical functions can be rescued while the costs of restructuring and resolving failing banks fall upon the bank's owners and creditors and not on taxpayers.

President Barroso said: "The EU is fully delivering on its G20 commitments. Two weeks ahead of the summit in Los Cabos, the Commission is presenting a proposal which will help protect our taxpayers and economies from the impact of any future bank failure. Today's proposal is an essential step towards Banking Union in the EU and will make the banking sector more responsible. This will contribute to stability and confidence in the EU in the future, as we work to strengthen and further integrate our interdependent economies"

Internal Market Commissioner Michel Barnier said: "The financial crisis has cost taxpayers a lot of money. Today's proposal is the final measure in fulfilling our G20 commitments for better financial regulation. We must equip public authorities so that they can deal adequately with future bank crises. Otherwise citizens will once again be left to pay the bill, while the rescued banks continue as before knowing that they will be bailed out again."

Key elements of the proposal:

A framework for resolution

The framework builds on recent efforts by several Member States to improve national resolution systems. It strengthens them in key respects and ensures the viability of resolution tools in Europe's integrated financial market.

The proposed tools are divided into powers of "prevention", "early intervention" and "resolution", with intervention by the authorities becoming more intrusive as the situation deteriorates.

1. Preparation and prevention:

First, the framework requires banks to draw up recovery plans setting out measures that would kick in in the event of a deterioration of their financial situation in order to restore their viability.

Second, authorities tasked with the responsibility of resolving banks are required to prepare resolution plans with options for dealing with banks in critical condition which are no longer viable (such as details on the application of resolution tools and ways to ensure the continuity of critical functions). Recovery and resolution plans are to be prepared both at group level and for the individual institutions within the group.

Third, if authorities identify obstacles to resolvability in the course of this planning process, they can require a bank to change its legal or operational structures to ensure that it can be resolved with the available tools in a way that does not compromise critical functions, threaten financial stability, or involve costs to the taxpayer.

Finally, financial groups may enter into intra-group support agreements to limit the development of a crisis and quickly boost the financial stability of the group as a whole. Subject to approval by the supervisory authorities and the shareholders of each entity that is party to the agreement, institutions which operate in a group would thus be able to provide financial support (in the form of loans, the provision of guarantees, or the provision of assets for use as collateral in transactions) to other entities within the group that experience financial difficulties.

2. Early intervention

Early supervisory intervention will ensure that financial difficulties are addressed as soon as they arise. Early intervention powers are triggered when an institution does not meet or is likely to be in breach of regulatory capital requirements. Authorities could require the institution to implement any measures set out in the recovery plan, draw up an action programme and a timetable for its implementation, require the convening of a meeting of shareholders to adopt urgent decisions, and require the institution to draw up a plan for restructuring of debt with its creditors.

In addition, supervisors will have the power to appoint a special manager at a bank for a limited period when there is a significant deterioration in its financial situation and the tools described above are not sufficient to reverse the situation. The primary duty of a special manager is to restore the financial situation of the bank and the sound and prudent management of its business.

3. Resolution powers and tools

Resolution takes place if the preventive and early intervention measures fail to redress the situation from deteriorating to the point where the bank is failing or likely to fail. If the authority determines that no alternative action would help prevent failure of the bank, and that the public interest (of access to critical banking functions, financial stability, integrity of public finances, etc.) is at stake, authorities should take control of the institution and initiate decisive resolution action.

Harmonised resolution tools and powers, together with the resolution plans prepared in advance for both nationally-active and cross-border banks, willensure that national authorities in all Member States have a common toolkit and roadmap to manage the failure of banks. The interference in the rights of shareholders and creditors which the tools entail is justified by the overriding need to protect financial stability, depositors and taxpayers, and is supported by safeguards to ensure that the resolution tools are not improperly used.

The main resolution tools are the following:

The sale of business tool whereby the authorities would sell all or part of the failing bank to another bank;

The bridge institution tool which consists of identifying the good assets or essential functions of the bank and separating them into a new bank (bridge bank) which would be sold to another entity. The old bank with the bad or non-essential functions would then be liquidated under normal insolvency proceedings;

The asset separation tool whereby the bad assets of the bank are put into an asset management vehicle. This tool cleans the balance sheet of a bank. In order to prevent this tool from being used solely as a state aid measure, the framework prescribes that it may be used only in conjunction with another tool (bridge bank, sale of business or write-down). This ensures that while the bank receives support, it also undergoes restructuring;

The bail-in tool whereby the bank would be recapitalised with shareholders wiped out or diluted, and creditors would have their claims reduced or converted to shares. An institution for which a private acquirer could not be found, or which could be complicated to split up, could thus continue to provide essential services without the need for bail-out by public funds, and authorities would have time to reorganise it or wind down parts of its business in an orderly manner. To this end, banks would be required to have a minimum percentage of their total liabilities in the shape of instruments eligible for bail-in. If triggered, they would be written down in a pre-defined order in terms of seniority of claims in order for the institution to regain viability.

Cooperation between national authorities

In order to deal with EU banks or groups that operate across borders, the framework enhances cooperation between national authorities in all phases of preparation, intervention and resolution. Resolution colleges are established under the leadership of the group resolution authority and with the participation of the European Banking Authority (EBA). The EBA will facilitate joint actions and act as a binding mediator if necessary.This lays the foundations for an increasingly integrated EU-level oversight of cross-border entities, to be explored further in the coming years in the context of the review of Europe's supervisory architecture.

Resolution funding

To be effective, the resolution tools will require a certain amount of funding. For example, if authorities create a bridge bank, it will need capital or short term loans to operate. If market funding is not available and in order to avoid resolution actions from being funded by the state, supplementary funding will be provided by resolution funds which will raise contributions from banks proportionate to their liabilities and risk profiles. The funds will have to build up sufficient capacity to reach 1% of covered deposits in 10 years. They will be used exclusively for supporting orderly reorganisation and resolution, and never to bail out a bank. National resolution funds would interact, notably to provide funding for resolving cross-border banks.

For an optimal use of resources, the resolution Directive also takes advantage of the funding already available in the 27 Deposit Guarantee Schemes (DGS). The DGS will provide funding, alongside the resolution fund, for the protection of retail depositors. For maximum synergy, Member States will even be allowed to merge the DGS and the resolution fund, as long as all the guarantees are in place to ensure that the scheme remains in position to repay depositors in case of failure.

Background

The crisis clearly demonstrated that when problems hit one bank, they can spread to the whole financial sector and well beyond the borders of any one country. It also showed that systems were not in place to manage financial institutions facing difficulties. Very few rules exist which determine what actions should be taken by authorities in the case of a banking crisis. That is why the G20 agreed that crisis prevention and crisis management frameworks had to be set up.2

The financial crisis provided clear evidence of the need for more robust crisis management arrangements at national level, as well as the need to put in place arrangements better able to cater for cross-border banking failures. There have been a number of high profile banking failures during the crisis (Fortis, Lehman Brothers, Icelandic banks, Anglo Irish Bank, Dexia) which have revealed serious shortcomings in the existing arrangements. In the absence of mechanisms to organise an orderly wind down, EU Member States have had no choice other than to bail out their banking sector. The Commission has already published in 2010 a Communication on a way forward on the subject (IP/10/1353).